Financial creditors cease to be related party to avoid exclusion should also be barred from CoC: SC

In a landmark judgment on 1 February 2021, the Supreme Court of India in Phoenix ARC Vs Spade Financial Services Ltd & others gave a very crucial judgment that those related party financial creditors (FCs) who cease to be related parties in order to circumvent the exclusion from the committee of Creditors (CoC) should also be considered as being covered by the exclusion as per the Section 21(2) of the Insolvency and Bankruptcy Code (IBC).

The first proviso of Section 21 (2) of IBC says that if a financial creditor is a related party of the corporate debtor, it will not have any right of representation, participation or voting in a meeting of the committee of creditors (CoC).

The Supreme Court ruled that while the default rule under the first proviso to section 21(2) is that only those FCs that are related parties currently would be debarred from the CoC, those related party FCs that cease to be related parties in order to circumvent the exclusion under the first proviso to section 21(2), should also be considered as being covered by the exclusion thereunder. “Otherwise, a related party FC can devise a mechanism to remove its label of a ‘related party’ before the corporate debtor undergoes CIRP, so as to be able to enter the CoC and influence its decision making at the cost of other FCs,” says the court.

The ruling says that the purpose of excluding a related party of a corporate debtor from the CoC is to obviate conflicts of interest which are likely to arise in the event that a related party is allowed to become a part of the CoC.

Also read: Key takeaways from Supreme Court judgement upholding amendments in Section 7, 11 and 32A

The exclusion under the first proviso to section 21(2) is related not to the debt itself but to the relationship existing between a related party FC and the corporate debtor.

As such, the FC who in praesenti is not a related party, would not be debarred from being a member of the CoC. However, in case where the related party FC divests itself of its shareholding or ceases to become a related party in a business capacity with the sole intention of participating the CoC and sabotage the CIRP, it would be in keeping with the object and purpose of the first proviso to section 21(2), to consider the former related party creditor, as one debarred under the first proviso, ruled the court.